Gilt mutual funds eliminate credit risk but investors need to be careful

Published: February 9, 2019 at 10:37 am

Gilt mutual funds are those that predominantly invest in government bonds (gilts).For a citizen, such bonds carry no credit risk, that is the risk of perceived or actual delay or default in interest payment*. However, this brings to the table a new of problems that investors need to know of. If you cannot stomach the possibility of credit risk in debt mutual funds, here is how you can use gilt mutual funds

* Gilt mutual funds are classified by rating agencies as “sovereign risk”.Internationally, the bonds of one country can be compared with another and a credit rating is assigned. For example, Moody’s current long term sovereign rating of Indian bonds is Baa2 with a stable outlook. This is 8 notches below AAA, but still considered investment grade.

In fact, India was arm twisted into opening its economy in the early nineties when it was on the verge of bankruptcy. Government bonds were near junk demanding 12% ish interest rates (EPF and PPF were hovering around this). So although it is technically incorrect to say gilts do not have credit risk, practically, for a citizen it is not of everyday relevance. If the government is unable to repay its debt to citizens, all of us will have much bigger problems to worry about than the fall in NAV of our debt mutual funds and who said what on Twitter.

Gilt mutual funds eliminate credit risk but investors need to be careful

Gilt mutual funds: Positives for the investor

  1. No credit risk.
  2. Suited for long-term goals as fixed income component, but periodic rebalancing is essential to reduce risk and lock in gains.

Gilt mutual funds: Negatives for the investor

Wait a minute.Just two positives? That is it? Depending on how you look it, that is a lot or that is it. Let us understand this better by looking at the negatives.

  • Cannot be used for short-term goals ( less than 5 years) or for simply parking money.  Short term gilt funds can be used but they are not longer available after the SEBI categorization rules
  • Daily volatility will become significantly higher when compared to liquid or ultra short term funds. Shown below is the NAV of SBI contant maturity gilt fund. The fund was converted from a short term gilt to a 10Y gilt fund due to SEBI rules. You can literally tell when the fund changed by looking at the NAV.

Daily NAV volatility of a gilt mutual fund

  • There will be months of month of low or even negative returns where the NAV stays “under water” (below a past maximum). Are people who complain about credit risk ready to face this prospect without complaining or feeling worried? I doubt it. The 200 day moving average of CCIL All Sovereign Bond – TRI is shown below. Notice that the NAV can be below its 200 day moving average for months (ignore the movement in the early 2000s when it was below for years!).

200 day moving average of CCIL All Sovereign Bond - TRI

While such dips present a buying oppurunity, it also means past returns would be erased. It is one thing if it happens in equity and quite another in “fixed income”. So tread with caution.

  • While credit downgrades are like Earhquakes where the NAV falls vertically down. gilt fund NAVs are more like soil erosion or deforestraion where the change is gradual and visible but not too sudden. To assume the latter is better than the former is folly.
  • AUM is a problem and choices are limited. In the 10Y gilt category where the fund only invests in 10-year bonds. Only one fund (the above SBI fund) has a reasonable AUM of  359 croes. All others have less than one tenth of that AUM!! In the normal gilt category, only three funds have a 1000+ crore.
  • Gilt funds can only be used for goals five years or more away. Even then, just like equity, one will have to remove money gradually or in one shot well before the goal else if there is a rate hike just before the goal deadline, there will be losses. So the tax efficiency of gilts are lower than other debt funds.

So are the negatives more than the positives? If you consider investor mentality, choosing gilts over other types of debt funds can be a case of jumping from the frying pan into the fire. I think investors are better off with lage AUM lilquid funds if they are worried about credit risk.

I would like to use gilt funds. How should I go about it?

The first thing to understand is you cannot eat your cake and have it too. You cannot get rid of one type of risk and then expect the gilt fund to give you good returns. Since there are no short term (<1Y) gilt funds anymore, you simply cannot expect anything from a gilt fund. There is too much volatility.

Of course, the same is true of any debt fund, but in the absence of credit risk, it is reasonable to expect something. The only problem (and a big one at that)  is finding a non-gilt fund with low credit risk. Well my point is, just because credit downgrades are taken off, does not mean the fund is safe and you can expect a return. Time value of money plays a big role in  medium and long term gilts. That is the NAV can keep moving down or nowhere for weeks to months.

You can only use them for medium to long term goals, preferably long term like retirement. You have two choices:

  • The 10Y gilt fund will be a lot more volatile then normal gilt funds but there will be not fund management risk. If you wish to actively rebalance between equity and debt depending on gains then this would be a good choice
  • All other gilt funds will behave like dynamic bond funds trying to move from short term to long term gilts depending on market supply and demand. They can get it right or wrong, but the day to day volatility will be lower than the 10Y gilt funds. If you want some amount of active management with yearly or occasional rebalancing, this would be a good choice.

Ideally gilt funds are supposed to fall when equity moves up and vice versa so that tactical asset allocation is possible. This happended during the pre-2008 bull run, but not since (not for substantial periods). So one cannot count on this. The bottom line however is, gilt investors should either periodically move in and out or face the music if they buy and hold. To assume credit free risk options are better is folly.

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